How Private Placement Financing Works

A private placement is a sale of shares or corporate bonds to pre-selected investors and institutions without offering them for sale on the open market.

A private placement is an alternative to an initial public offering (IPO) for a company seeking to raise capital for expansion.

It offers an opportunity for an investor to buy shares of a company from the company itself.

These investors could include wealthy individual investors, banks and other financial institutions, mutual funds, insurance companies, and pension funds.

Private placements can be done by private companies or publicly traded companies as a secondary stock offering. There is no need to involve brokers or underwriters.

Financing can be arranged through banks or specialized financial institutions.

A private placement allows for tailored terms and structures to meet the specific financing needs of the issuer.

Registration exemption for private placement offerings is provided by Regulation D of the 1933 Act. Regulation D permits an issuer to sell securities to a specific group of accredited investors.

There are three distinct offerings provided under Regulation D. Each of the three offerings is controlled by a rule: Rule 504, Rule 505, and Rule 506.

• Rule 504: Issuers can offer and sell up to $1 million of securities a year to all type of investors. No disclosure requirements.

• Rule 505: Issuers can offer and sell up to $5 million of securities a year to unlimited accredited investors and 35 non-accredited investors. Disclosure of financial information needed when selling to non-accredited investors.

• Rule 506: An unlimited amount of money can be raised provided the issuer does not participate in solicitation or advertising. Only 35 non-accredited can take part if they meet specific criteria.

Raising financing from investors is a securities transaction. Even under Regulation D, anti-fraud rules apply.

Compliance with these rules is critical to avoid severe civil or even criminal liability.

A private placement memorandum (PPM) is a legal document provided to prospective investors when selling equity or debt in a company. It is sometimes referred to as an offering document.

The offering memorandum provides investors with the information they need. It also protects the company in the event of an investor complaint.

It is critical that your PPM document reflect the most current state of the law.

Ask the person preparing your PPM what exemptions the offering should fit into.

Also ask if the drafter will be handling the regulatory filings for both state and federal, as well as how investor complaints will be resolved.

A strong PPM not only impresses investors but also stands as your shield against legal exposure and compliance issues.

If you find a lawyer who is willing to review your PPM document, it is likely to be at a substantial cost.

You may receive price quotes ranging from $2,500 to $35,000 for writing a private placement memorandum.

Big law firms will likely charge at least $35,000 to draft a PPM. These firms may also require an equity stake in your company.

There are small law firms or solo practitioners, who will draft a PPM for anywhere from $5,000-$15,000.

There are small non legal firms that offer PPM drafting services for under $5,000. They generally model your PPM on a template or sample PPM.

• A higher degree of flexibility and ability to customize the transactional structure to meet the needs of the targeted investor.

• The entrepreneur and advisors set and drive the terms (not the institutional investors or lender.

• PPM investors are more patient and “vested” in your success than other types of investors.

• Introduces entrepreneurs to the obligations and best practices in reporting to minority shareholders.

• Speed of access to the capital markets.

• Lower transactional costs than most other types of business financing.

Offering a private placement is one of the best ways for a company to raise financing for expansion or to sustain their operations.

Taking a business loan from a bank would not raise enough funds, and incur interest expenses. Companies use private placements as a capital raising tool.

Private placements are often priced at a discount to the company’s current market price.

It helps make the opportunity more attractive to prospective investors.

Companies have an easier time raising capital they need, when they offer terms that are appealing to investors.

By issuing new shares, a company dilutes its current stock structure. This means shareholders of the company stock now own less of it.

The extra share dilution in a private placement is offset by the value of the cash raised by the company.

The main drawback of a private placement is that shareholders own a smaller percentage of the company.

You must be an accredited investor to participate in a private placement.

Securities regulators want to ensure that investors choosing to get into private placements know the risks.

The terms, rewards and gains of a private placement may be attractive. You could also lose your investment.

The company raising the funds through private placement needs to know that you are qualified to get in the deal.

You must show that you are an accredited investor. Private placements can be a lucrative investment option.

Raising more funds than planned for is not necessarily a good thing for a company.

The company may not have a plan in place for proper use of the money raised.

The stock becomes diluted and they can attract penalties from securities regulators.

Publicly listed companies looking to raise financing through a private placement must obtain approval from their exchange.

This approval is contingent on certain pricing and gross proceeds limitations.

A company raising money through private placement offering has the final say in who gets how much of their shares.

It takes 6-8 weeks to complete a private placement transaction.

The timeline for completing a private placement will vary depending on the size and credit profile of the issuer and lender.

FIRST STAGE

This is when the issue is offered to investors and can last from 1-3 weeks.

SECOND STAGE

This is when discussions between the issuer and the investor on the specifics involved with the investment, such as pricing or legal terms take place leading up to closing.

THIRD STAGE

This is the information research and due diligence process.

FOURTH STAGE

This is when the investor will determine a credit rating for the company issuing the private placement. The higher the risk, the lower the quality rating.

FIFTH STAGE

This is when the investor determines what interest rate is needed to compensate for the associated risk.

Pricing is determined by adding a credit risk premium to the corresponding U.S. Treasury rate.

SIXTH STAGE

This is when the private placement investor and the company agree to lock-in the interest rate.

The coupon is based on the agreed upon spread and the prevailing U.S. Treasury rate at a specific time. Multi-currency swap are executed at this stage.

There are important considerations for a company when choosing a private placement investor.

Some of the key characteristics to look out for include:

• The investors show interest in the businesses and work to understand how it operates.

• The private placement investor has the capacity to grow as a financial partner.

• They should have the knowledge and experience to help a company navigate during challenging times.

• They act fast, are responsive, and have access to key decision-makers.

• The private placement investor demonstrates a constant appetite for private placement debt.

• The investor follows through on their commitments.

For a private company, private placement offering has no effect on share price since there are no pre-existing shares.

With a publicly-traded company, the percentage of equity ownership that existing shareholders have prior to the private placement, is often diluted by the secondary issuance of additional stock.

This increases the total number of shares outstanding. The extent of the stock dilution is proportionate to the size of the private placement offering.

For instance, if a company has 100,000 shares outstanding prior to a private placement offering of 10,000 shares, the private placement would result in existing shareholders having 10 percent less equity in the company.

If the company offered an additional 100,000 shares through private placement, the ownership percentage of existing shareholders would reduce by 50 percent.

Dilution of shares leads to a decline in share price. A private placement offering affects the share price quite in the same way as a stock split.

Long-term effect on share price is much less certain. It also depends on how effectively the company makes use of the additional finances raised from the private placement.

A company on the verge of insolvency, can do a private placement as a means of avoiding bankruptcy.

Be ready and have a hit list; you certainly don’t want to take the time and expense to prepare a PPM and not have a clue who to show it to when it’s completed.

Prepare a list of targeted investors well in advance to make sure the offering is viable, and to help your lawyers evaluate compliance issues.

Make sure the economic terms are attractive; remember that unlike a venture capital deal in which the business plan is presented and then a term sheet is negotiated.

The PPM offering is not intended to be negotiated at all.

You must have a good sense of the attractiveness and fairness of the terms of the offering in advance of distribution of the document.

Find special benefits or rights for the investors; for early-stage companies, the only real appeal to investors is the opportunity to get in on the ground floor of what might be the next big thing.

Your challenge is to find some special benefit or right to entice investors to invest in your business.

Do it right the first time; Investors don’t want to see a lot of waste. But they will expect to see a well-written and properly formatted document without typographical errors or poor grammar.

They will ask for exhibits and other information to help them understand the business and the risks inherent in the offering.

Large private placement investors can negotiate the buy price per share and amount invested with a company.

They can get large share positions and don’t have to deal with the market’s fluctuations.

Public companies offer new shares at a discount to current market prices.

This depends on the securities regulator, and could be as high as a 20% discount to the current market price.

The exact price used can be calculated relative to volume weighted adjusted pricing.

For instance, if a stock was trading at $10 for a while before quickly rising to $15, a private placement offering would likely be permitted for $10.

The pricing would still be subject to regulatory approval.

Buying a private placement comes with all the usual risks associated with buying shares of a publicly listed company.

Some of the risks associated with investing in private placement includes;

Bankruptcy: Business may fail or go bankrupt.

Low liquidity: There may not be enough cash flow to easily exit a position.

Long-hold period: It may take longer for your investment to give returns than you initially projected.

You cannot sell your shares for the duration of the hold period. Your shares are locked up. Most of the time, the hold period is only 4 months long.

Capital raised from issuing private placement offerings are used for:

1. Debt Refinancing

2. Debt Diversification

3. Expansion or Growth

4. Business Acquisitions

5. Stock Buyback/Recapitalization

6. Privatization of a Public Company

7. Employee Stock Ownership Plan

• Few legal fees because no securities registration is necessary

• Less negotiation before the company receives funding.

• The exemption under Regulation D allows companies to raise capital while keeping financial records private.

• The process of underwriting is faster, and the company gets funding sooner.

• Different assets even bonds can be sold more quickly. A company can sell more complex bond offerings to accredited investors without bond ratings.

• A company can file a private placement and remain privately owned. No need to go public to raise funds

• Easier to choose investors with similar objectives.

• Provides flexibility in the amount and type of funding.

• Return on the investment can be achieved over a longer time period.

• Requires less investment of money and time than public share flotation

• Provides longer maturities than typical bank financing, at a fixed-interest rate.

1. Private placement bonds earn a higher rate of interest.

2. Bond offers little assurance to a buyer without some form of collateral.

3. An investor of a private placement company may want a larger percentage of ownership or a guaranteed fixed dividend payment for each stock they own.

4. Reduced market for the bonds or shares which may have a long-term effect on the value of the business.

5. Limited number of potential investors who may not want to invest substantial amounts.

6. The need to issue bonds or shares at a substantial discount to compensate investors for their greater risk and long-term returns